France’s Firebreak Weakens

France had pinned its hope that threat to EMU would be turned back before the wolf came it its door. The Italian political tensions come at the poor time for France. Its ability to absorb shocks is terrible constrained.

Recall what has happened in recent days. Q4 GDP showed a larger contraction than expected. The flash PMI showed the contraction is carrying into 2013 (though not for Germany). The EU’s updated forecasts released last week shows France significantly overshooting the 3% deficit target this year.

A confrontation over its budget is looming. Do not be misled by German Finance Minister Schaeuble’s recent comments. Many in the media read Schaeuble’s comments as defense of France, saying it will not flout the rules. He wants to prevent a German-French confrontation. He wants the EU to rule on what this means for the stability and growth pact.

German representatives on the European Central Bank–Asumussen and Weidmann were more directly confrontational. They argued that it is important for the credibility of EMU that France sticks to the EU-mandated deficit targets. Separately, Austria and Finland are also insisting that France make a greater effort. For their part, French officials have intimated that they will request an extra year to meet the target as EU Commissioner Rehn has suggested may be possible on a case-by-case basis.

French bonds have advanced today, but both the 2-year and 10-year yields have declined the least EMU the core EMU bond markets. Still, the pressure is modest. The 11 bp spread between German and French 2-year notes is the widest of the year, but still well below levels since in Q4 12. The correlation between the two on the basis of levels is still a high 0.97.

The 10-year interest rate differential is just above 72 bp, also the highest for the year and is actually back to levels since last November. The correlation is also high near 0.96.

Nevertheless, the divergence between German and French interests appear to be growing. This is clearly evident in the fx space, where France presses for a weaker euro, while Germany is nonplus. French Industry Minister Montebourg is calling on the ECB to fight back in the “currency wars”. He calls on the ECB to be less dogmatic and more pragmatic. Yet from the SMP, to the OMT, the ECB has shown itself to be very pragmatic. Arguably, French insistence that the strong euro is the main obstacle to its exports is dogma.

French President Hollande has also taken on the ECB. A few weeks ago, he told the European parliament that the euro shouldn’t be determined by the markets. Clearly he was rebuffed by the G7 and G20 statements (as much as Japan was). However, it does illustrate that France is singing from a different song book.